What is a Shareholder Derivative Action?

What is an example of a derivative suit?

An example of a derivative action includes a breach of fiduciary duty by a director or officer. A derivative suit often includes an allegation against an officer or director for fraud and conflicts of interest. Some examples of the types of behavior that can result in shareholder derivative actions being acted upon include:

• Decisions by company insiders that put the business at risk, such as breaches of environmental protection laws or consumer protection laws
• Insider conduct that elicits an investigation between the SEC or the Department of Justice
• Illegal or fraudulent activity by company insiders
• Violations of fiduciary duty by executives, managers, officers, or board members
• Insider trading
• Corporate insiders are acting against the company and for themselves.
• Backdating stock options
• Squandering corporate assets
• Accounting problems, including misleading or false financial statements.
• Executive compensation indiscretions
• Conflicts of interest among the corporation and corporate insiders

When a company stockholder believes these problems exist, they can file a shareholder derivative action to stop the harmful behavior from further damaging the company.

How Do Shareholders Bringing a Derivative Action?

Shareholders begin the derivative action process by demanding that the board of directors filed a lawsuit against the wrongdoer. This is called making a demand on the board. The shareholder derivative actions allege that directors breached their fiduciary duties, either of care or loyalty to the company. A shareholder can only file a derivative suit when the corporation has a valid cause of action but the board of directors refused to pursue it.

After the shareholder’s demand on the board, there are two things a board may take in response. These include:

• Filing Suit

If the board chooses to file suit, the board may grant the shareholders’ requests and file a lawful action against the party—usually a director or corporate officer—suspected of harming the corporation. Importantly, if this occurs and the board decides to take action, the shareholder who made the demand cannot bring direct action.

• Rejecting the Shareholder’s Demand

In some scenarios, the board decides that bringing a lawful action is not in the corporation’s best interests. In this case, the board rejects the shareholder’s demand or does not respond within a suitable time frame.

The board, upon receiving the request to bring the suit against the defendant, may grant the request to file the suit, dismiss the request, or appoint a special litigation committee. The board or special committee may decide that it is not in the best interest of the corporation to bring a legal action. The business judgment rule dictates whether or not the board supports legal action.

What is the Business Judgement Rule?

The business judgment rule is a rule that gives a corporation director immunity from responsibility when a party sues on the grounds that the director breached their duty to the corporation.

The business judgment rule presumes that corporate directors act in three manners:

• In good faith
• While properly informed
• With a sincere belief that the directors have the best interests of the company and its shareholders in mind

If the board decides not to sue, their decision is typically binding unless the owners can show that the board decision is:

• Biased
• Not made in good faith
• Reckless or dangerous
• Intending to purposefully harm the company
• Creating a Special Litigation Committee 

This committee’s creation helps shield the board from allegations of bias, failing to meet the provisions of the business judgment rule, or dealings considered in bad faith.

Once the Special Litigation Committee (SLC) makes a decision, it is difficult for shareholders to overcome it. Therefore, the shareholders may also be unable to bring a derivative action against the company.

Sometimes, however, owners can file their derivative action without asking the board. For shareholders to bring a derivative lawsuit without the board’s approval, they must effectively illustrate that the directors:

• Do not possess the independence to act with an obligation to the company
• Have breached the business judgment rule
• Are you dealing with a conflict of interest

If shareholders can prove one or more of these ideas, the court may let them bring the lawsuit without the board’s approval.

What is the result of a derivative suit?

A derivative suit is a claim brought by a shareholder on behalf of the company in relation to a breach of duty by a director. A derivative action will usually be filed when the majority wrongfully prevent the company bringing or proceeding with such a claim itself. In nearly all states, any damages or other proceeds collected as a result of a successful shareholder derivative lawsuit are retained by the corporation, rather than the shareholder who initiated the suit. Shareholder derivative action is vital for shareholders to protect the company. A derivative suit also help the shareholders find misconduct, fraud, and overall wrongdoing at large corporations.

A shareholder derivative action is a lawsuit brought by a shareholder for the benefit of a corporation. Therefore, shareholders typically do not receive direct damages or proceeds from shareholder derivative actions. Plaintiffs’ counsel who successfully litigates a derivative action may be entitled to an award of attorneys’ fees and expenses.